September 29, 2009

Congressional proposals regarding derivatives on carbon dioxide subject these products to the most onerous regulatory regime: they require trading on exchange, just like derivatives on agricultural products. This probably reflects the fact that those legislators who are most concerned about carbon vapor are the same ones who get the vapors from derivatives.

The rules for buying and selling pollution credits under a proposed U.S. “cap-and- trade” program shouldn’t be tougher than those being debated in Congress for other markets, the International Emissions Trading Association said today.

Some lawmakers have expressed concern that a new U.S. carbon market may be more vulnerable than others to manipulation and fraud. They are considering special rules for the cap-and- trade program that would restrict OTC dealing in futures and other derivatives contracts, block the involvement of banks and impose price controls.

‘Out of Step’

These proposals are “out of step” with the new regulations being considered for other markets, IETA said. The group said concerns over manipulation and fraud can be dealt with through “stringent disclosure requirements of all OTC transactions” to the Commodity Futures Trading Commission.

Manipulation of carbon derivatives would not be impossible: even though the costs of delivery are theoretically zero (involving only book entries), just as in Treasury markets there will be frictions that can be exploited by a manipulator. However, it is better to deter such manipulations ex post than attempt to prevent them by imposing tight trading regulations.

Moreover, an exchange trading requirement will prevent many market participants from realizing the risk management benefits of derivatives. Most firms that face carbon price risk (in the event of the adoption of a cap and trade scheme) will face long-lived exposures that interact in a complex way with other risk exposures. For instance, in a cap and trade world a power plant faces risks from power prices, fuel prices, and the quantity of power generated, as well as carbon prices. Moreover, these exposures are likely to be non-linear in nature (due to the options inherent in plant operations, like the ability to turn it on and off, and perhaps fuel switching options). In addition, they are likely to be very long-lived, because the plant is long-lived.

In contrast, most liquid exchange traded derivatives are simple, vanilla, linear products (forwards) with short maturities, or simple vanilla options with shorter maturities. These are not well-suited to managing the complex risks that many carbon-intensive companies are likely to face.

Furthermore, the costs of rigid mark-to-market collateralization are high, and many market users could avoid these costs by trading customized OTC products.

This all means that requiring only exchange trading of carbon derivatives is likely to greatly increase the costs, and reduce the effectiveness, of carbon price risk management. This will force firms exposed to carbon risk to bear risks that cost more for them to incur than it would cost the potential counterparties of customized derivatives. By impeding efficient risk transfer, onerous regulations will increase the costs of a cap and trade system.

This is bad public policy. Congress should be looking for ways to mitigate the costs of a CO2 trading system, not increasing them. Impeding carbon risk management would do just that.